Commercial real estate loans have been integral to the success of many small banks. Long before the Great Recession made everyone in the banking industry rethink nearly everything about how they did business, numerous community banks were highly dependent on CRE loans for revenue.
As the economy recovered from its economic downturn, many smaller banks renewed their emphasis on CRE, seeing the segment as an opportunity for greater growth with less risk than mortgage business. Now, regulators are ringing the alarm bell that some smaller financial institutions may be overexposed. They’ve invested too heavily in developing CRE business to the extent that the segment represents a greater share of their overall revenue stream than regulators deem prudent.
In December 2015, the Federal Reserve, the FDIC and the Comptroller of Currency issued a joint statement warning banks to proceed with caution in developing CRE business. Regulators warned an “easing of CRE underwriting standards, including less-restrictive loan covenants, extended maturities, longer interest-only payment periods and limited guarantor requirements” are creating risk around CRE lending. What’s more, regulators said, “a greater number of underwriting policy exceptions and insufficient monitoring of market conditions to assess the risks associated with these concentrations” were cause for concern.
“Historical evidence demonstrates that financial institutions with weak risk management and high CRE credit concentrations are exposed to a greater risk of loss and failure,” regulators cautioned.
Rating firm Fitch seems to agree there’s reason to worry. In a CFO report, Fitch noted American financial institutions have record CRE loans on the books, and unsustainable lending trends portend a softening in the CRE market.
Migrating away from CRE
In response to increased regulatory scrutiny and market factors like those Fitch cites, many small banks have begun reducing their CRE business or withdrawing from the marketplace altogether. According to a New York Times report, they’re turning to other growth opportunities such as acquisitions.
Small banks drawing away from selling CRE loans is bad for business all around. Not only do CRE-shy community banks risk losing a critical revenue stream, their decampment from CRE lending will create an increasingly underserved market in a sector that’s important to the American economy. Community banks have long been the small-business owner’s go-to lenders for all types of business loans — including commercial real estate loans needed to secure or refinance the SBO’s own offices and facilities.
Turning from CRE business to acquisitions for driving growth also has another negative side effect on banking — it’s intensifying the consolidation of the industry. In the third quarter of 2016, the total number of FDIC-insured financial institutions in the country dipped to fewer than 6,000, American Banker recently reported. Historically, when market forces cull financial institutions from the industry, the ranks of community banks and credit unions suffer disproportionate losses.
Finally, the withdrawal of community banks from the CRE marketplace leaves the door open to disruptors. Commercial real estate borrowers won’t simply stop buying until small lenders feel more secure again. They will turn to other, nontraditional sources of funding, further eroding the position of traditional financial institutions in the marketplace.
Walking away from CRE is simply not an option for many small banks active in this marketplace. And even for those with the wherewithal to curtail CRE lending, taking action to minimize risks would be a better approach than devaluing this important revenue stream.
Fortunately, in their cautionary statement, regulators also provided guidance for financial institutions to successfully manage CRE lending risks. They pointed to best practices of financial institutions that successfully weathered economic down cycles, including:
- Established solid loan policies, underwriting standards, credit-risk management practices and concentration limits, and had the board or a designated committee sign off on these policies.
- Carefully reviewed lending strategies that make it clear what markets the financial institution will focus on, and the types of property it will lend for. These strategies should set out limits for credit and other asset concentrations.
- Continually and conservatively assessed market opportunities and their CRE loan portfolios.
- Communicated fully with their boards on CRE lending practices and risks, and provided adequate information for boards to make informed decisions.
- Implemented and maintained management information systems.
By upgrading their credit-analysis procedures; strengthening internal controls, networks and software; honing their ability to pinpoint trouble spots ahead of time; and leveraging data and technology to identify the pieces of best potential business, financial institutions can remain in the CRE marketplace. What’s more, they’ll be well positioned to mitigate risks and satisfy regulatory concerns.